After 5 months of focused work with an amazing team, I am proud to announce Liquity, a new decentralized borrowing protocol designed to generate unprecedented liquidity against Ether as collateral!

Liquidity is issued interest-free in LUSD, the protocol’s native stablecoin which is pegged to the US Dollar. As opposed to other decentralized stablecoins, LUSD is fully redeemable at face value for the underlying collateral. Like existing stablecoin systems, Liquity allows users to mint tokens in a self-service manner; however, other systems have complex governance mechanisms which are required to maintain the USD-peg by updating fees or interest rates. Liquity replaces the need for interests and human intervention by algorithmically adjusted redemption and loan issuance fees to support its currency. Both fees are initially set to 0% and increase with the redeemed amounts, while tending to return to zero in times of low redemption activity.

A borrower first locks up Ether in a smart contract and creates an individual liquidity position called a “Trove”. Each Trove is required to have a minimum collateralization ratio of only 110%, which is unparalleled in DeFi space. The borrower can then mint LUSD tokens, which are calculated as a debt against collateral. For Ether that is worth $100, the borrower can obtain up to 90.91 LUSD. When the borrower is ready to retrieve their collateral, they simply return the LUSD to the contract to repay their loan and free up their collateral.

Lower collateral requirements contribute to better capital efficiency. For example, if the liquidation ratio was set to 150%, risk-averse borrowers might want to keep their Trove’s collateral ratio above 300% at all times so that the position would survive a sudden collateral price drop by up to 50%. If liquidations only occur below a ratio of 110%, the borrower could have the same comfort level by maintaining a collateral ratio of only 220%. Better capital efficiency contributes to a more liquid Ether market and facilitates integration with other DeFi projects through higher ROI.

High-collateral borrowers and Stability Pool depositors provide stability to the system. They are rewarded for their roles by receiving collateral surplus gains from Troves that are liquidated. In addition, the depositors will receive LQTY tokens as a kickback from front ends. LQTY can be staked in order to earn a proportion of the protocol revenue stemming from issuance and redemption fees.

Highly capital-efficient through instant liquidation

A novel liquidation mechanism allows Liquity to be more capital-efficient than its competitors while remaining robust against price shocks. Liquidation is needed to ensure that the protocol can cover outstanding debt before a Trove’s collateral ratio falls below 100%. The Stability Pool is Liquity’s primary mechanism to instantly absorb Troves with insufficient collateral. It is maintained by users who deposit LUSD in exchange for the future collateral of liquidated Troves. When a Trove falls below the minimum collateral ratio of 110%, the system liquidates its debt by burning an identical amount of LUSD tokens held in a Stability Pool. This stands in contrast to existing platforms which auction off collateral in a lengthy process, facing difficult market situations and further price drops.

In return for the LUSD that is burned from the Stability Pool, all the collateral of each liquidated Trove is sent to the Stability Pool and distributed proportionally among all depositors. This mechanism is expected to yield a net gain to the depositors: the collateral is almost always worth more (in USD) than the LUSD tokens that are burned to offset the debt. This holds because the liquidation is triggered below a collateral ratio of 110%, but with a very high probability above 100%.

For example, if a Trove with $109 worth of ETH and 100 LUSD of debt is liquidated, 100 LUSD are burned and the Stability Pool depositors receive $109 worth of ETH. This means the “liquidation penalty” under normal system operation is no more than 10%, much lower than in other competitors.

If the amount of LUSD in the Stability Pool goes to zero, the system moves to the second phase of the liquidation process in which it redistributes the remaining defaulted Troves to all existing Troves, in proportion to their collateral ratio. This means that Troves which are heavily collateralized will receive more debt and collateral from liquidated positions than those with low collateralization, ensuring that the system doesn’t create cascading liquidations. By redistributing the riskiest positions to the safest and adjusting the incentive structure in times of low collateralization, Liquity quickly stabilizes itself via direct feedback loops.

As a final backstop, the system provides a Recovery Mode. Recovery Mode is triggered if total system collateralization falls below the Critical Collateral Ratio, set to 150%. When this happens, the riskiest Troves are liquidated (even if they are over 110% collateralized) until the Critical Collateral Ratio threshold is met. The Recovery Mode acts a self-negating deterrent: the possibility of it actually guides the system away from ever reaching it. These measures ensure that the system’s overall collateralization ratio stays at a healthy level.

Price stability through redemption

As with fiat-backed stablecoins, LUSD is redeemable at face value for the underlying collateral. The value of LUSD in the system is fixed at $1. This means that at any time, a user can redeem 1 LUSD for its corresponding value in ETH. Whenever 1 LUSD trades below $1, holders and arbitrageurs are incentivized to redeem 1 LUSD for $1 worth of ETH. This helps to stabilize the price of LUSD through direct arbitrage rather than by relying on indirect monetary interventions like variable interest rates set by governance.

When redeemed, the system uses the received LUSD to repay the riskiest Trove(s) with the lowest collateral ratios and transfers the respective amount of ETH to the redeemer. While redemption causes no net loss to the affected borrowers (who lose the same amount of debt as they lose collateral), it has a positive effect on the overall collateralization of the system. This also creates an incentive to make sure that Troves are sufficiently collateralized relative to all other Troves, improving overall system security.

One protocol, many front ends

Liquity is a protocol rather than a platform and is controlled by nobody. As such, it outsources the operation of front ends to third parties that are willing to run a web interface to the protocol.

We are pioneering an incentive structure for decentralized front ends which will maximize censorship resistance while also helping bootstrap the network. Front ends will continuously receive LQTY tokens based on the amount of LUSD deposited through them and compete for users via the kickback rate that they can freely set between 0% and 100%.

If you would like to know more about Liquity or if you are interested in becoming a front end operator, please visit www.liquity.org and get involved!

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